Why is the US Repo crisis ongoing?

The US Repo crisis is something that seems to turn up every day, or if you prefer as often as we are told there is a solution to trade war between the US and China. On Friday the New York Federal Reserve or Fed provided another US $72.8 billion of overnight liquidity in return for Treasury Bonds ( US $56.1 billion) and Mortgage-Backed Securities ( US $16.7 billion). So something is still going on in spite of the fact that we have two monthly plus Repos ( 42 days) for US $25 billion each in play and 3 fortnightly ones totalling around US $59 billion. So quite a bit of liquidity continues to be deployed and this is before we get to the Treasury Bill purchases.

In accordance with this directive, the Desk plans to purchase Treasury bills at an initial pace of approximately $60 billion per month, starting with the period from mid-October to mid-November.

As an example Friday saw some US $7.525 billion of these bought. So the sums are getting larger.

How did this start?

The Bank for International Settlements or BIS which is the central bankers central bank puts it like this.

On 17 September, the secured overnight funding rate (SOFR) – the new, repo market-based, US dollar overnight reference rate – more than doubled, and the intraday range jumped to about 700 basis points. Intraday volatility in the federal funds rate was also unusually high. The reasons for this dislocation have been extensively debated; explanations include a due date for US corporate taxes and a large settlement of US Treasury securities. Yet none of these temporary factors can fully explain the exceptional jump in repo rates.

Indeed, as for a start the issue has proved to be anything but temporary.

Where the BIS view gets more interesting is via the role of the banks or rather a small group of them.

US repo markets currently rely heavily on four banks as marginal lenders. As the composition of their liquid assets became more skewed towards US Treasuries, their ability to supply funding at short notice in repo markets was diminished.

As the supply of reserves fell in the QT or Quantitative Tightening era they stepped up to the plate on a grand scale.

As repo rates started to increase above the IOER from mid-2018 owing to the large issuance of Treasuries, a remarkable shift took place: the US banking system as a whole, hitherto a net provider of collateral, became a net provider of funds to repo markets. The four largest US banks specifically turned into key players: their net lending position (reverse repo assets minus repo liabilities) increased quickly, reaching about $300 billion at end-June 2019 . At the same time, the next largest 25 banks reduced their demand for repo funding, turning the net repo position of the banking sector positive (centre panel, dashed line).

So things became more vulnerable as we note this.

At the same time, the four largest banks held only about 25% of reserves (ie funding that they could supply at short notice in repo markets).

Then demand for Repo funding was affected by the US Treasury.

After the debt ceiling was suspended in early August 2019, the US Treasury quickly set out to rebuild its dwindling cash balances, draining more than $120 billion of reserves in the 30 days between 14 August and 17 September alone, and half of this amount in the last week of that period. By comparison, while the Federal Reserve runoff removed about five times this amount, it did so over almost two years

As you can see the drain from QT was added to in spite of the fact that the market had become more vulnerable due to the lack of players. There was a clear lack of joined up thinking at play and perhaps a lack of any thinking at all. A factor here was something the BIS identifies for the banks.

For instance, the internal processes and knowledge that banks need to ensure prompt and smooth market operations may start to decay. This could take the form of staff inexperience and fewer market-makers, slowing internal processes

After a decade the experienced hands had in general moved on.

But it was not enough to collapse the house of cards. There were other nudges as well on the horizon.

Market commentary suggests that, in preceding quarters, leveraged players (eg hedge funds) were increasing their demand for Treasury repos to fund arbitrage trades between cash bonds and derivatives. Since 2017, MMFs have been lending to a broader range of repo counterparties, including hedge funds, potentially obtaining higher returns.

So hedge funds were playing in the market but as it happened were not an issue for a while as the US Money Market Funds (MMF) turned up. But then they didn’t.

 During September, however, quantities dropped and rates rose, suggesting a reluctance, also on the part of MMFs, to lend into these markets. Market intelligence suggests MMFs were concerned by potential large redemptions given strong prior inflows. Counterparty exposure limits may have contributed to the drop in quantities, as these repos now account for almost 20% of the total provided by MMFs.

So there is a hint that maybe a hedge fund or two became such large players that they hit counterparty limits. Also redemptions from MMFs would hardly be a surprise as we note the interest-rate cuts we have seen in 2019.

Why should we care?

There is this.

 Repo markets redistribute liquidity between financial institutions: not only banks (as is the case with the federal funds market), but also insurance companies, asset managers, money market funds and other institutional investors. In so doing, they help other financial markets to function smoothly.

So they oil the wheels of financial markets and when they don’t? Well that is one of the causes of the credit crunch.

The freezing-up of repo markets in late 2008 was one of the most damaging aspects of the Great Financial Crisis (GFC).

In case you did not know what they are.

A repo transaction is a short-term (usually overnight) collateralised loan, in which the borrower (of cash) sells a security (typically government bonds as collateral) to the lender, with a commitment to buy it back later at the same price plus interest.

Also it is one of those things which get little publicity ( mostly ironically because they usually work smoothly) but there is a lot of action.

 Thus, any sustained disruption in this market, with daily turnover in the US market of about $1 trillion, could quickly ripple through the financial system.

Comment

Some of the factors in the Repo crisis were unpredictable. But it is also true that the US Fed was at best rather flat-footed. There had been a long-running discussion over the use of Interest On Excess Reserves or IOER to banks on such a scale which was not resolved. Then there was the way that so few banks (4) were able to become such large players creating an obvious risk. Then the role of the MMFs as by their very nature they flow into and out of markets and are likely to flow out when interest-rates are declining.

The BIS analysis adds to what we know but changes in stocks give us broad trends rather than telling what flowed where or rather did not flow on September 17th or since. As David Bowie put it.

Ch-ch-ch-ch-changes
Turn and face the strange
Ch-ch-changes
Don’t want to be a richer man
Ch-ch-ch-ch-changes
Turn and face the strange
Ch-ch-changes
There’s gonna have to be a different man
Time may change me
But I can’t trace time

Number Crunching

The BIS has been looking into some other areas.

An analysis of the #TriennialSurvey finds that global notional for #OTCderivatives rose to $640 trn in 2019, dominated by #InterestRateDerivatives

Average daily turnover of OTC interest rate derivatives more than doubled over 2016-19 to $6.5 trillion, taking OTC markets’ share to almost half total trading

30 years, 53 countries, 1,300 reporting dealers, and $6.6 trillion daily FX trades,

Weekly Podcast

 

The central banks are losing their grip as well as the plot

The last 24 hours have shown an instance of a central bank losing its grip and another losing the plot. This is significant because central banks have been like our overlords in the credit crunch era as they slashed interest-rates and when that did not work expanded their balance sheets using QE and when that did not work cut interest-rates again and did more QE. This made Limahl look rather prescient.

Neverending story
Ah
Neverending story
Ah
Neverending story
Ah

Also in terms of timing we have today the last policy meeting of ECB President Mario Draghi who has been one of the main central banking overlords especially after his “What ever it takes ( to save the Euro) ” speech. Next month he will be replaced by Christine Lagarde who has given an interview to 60 Minutes in the US.

Christine Lagarde shows John Dickerson how she fakes drinking wine at global gatherings.

US Repo Problems

Regular readers will recall that we looked at the words of US Federal Reserve Chair Jerome Powell on the 9th of this month.

To counter these pressures, we began conducting temporary open market operations. These operations have kept the federal funds rate in the target range and alleviated money market strains more generally.

This involved various moves as the overnight Repos found this added too.

Term repo operations will generally be conducted twice per week, initially in an offering amount of at least $35 billion per operation.

These have been for a fortnight and added to this was a purchase programme for Treasury Bills.

In accordance with this directive, the Desk plans to purchase Treasury bills at an initial pace of approximately $60 billion per month, starting with the period from mid-October to mid-November.

Regular readers will recall that I described this as a new version of QE and it has turned out that the Treasury Bill purchases will be larger than the early estimates by at least double.

This theme of “More! More! More!” continued yesterday with this announcement from the New York Federal Reserve.

Consistent with the most recent FOMC directive, to ensure that the supply of reserves remains ample even during periods of sharp increases in non-reserve liabilities, and to mitigate the risk of money market pressures that could adversely affect policy implementation, the amount offered in overnight repo operations will increase to at least $120 billion starting Thursday, October 24, 2019.  The amount offered for the term repo operations scheduled for Thursday, October 24 and Tuesday, October 29, 2019, which span October month end, will increase to at least $45 billion.

Apologies for their wordy opening sentence but I have put it in because it contradicts the original statement from Jerome Powell. Because the “strains” seem to be requiring ever larger interventions. Or as Brad Huston puts it on Twitter.

9/17: We’re doing repos today and tomorrow.

9/19: We’re extending repos until 10/10. $75B overnight, $30B term

10/4: We’re extending repos until 11/4

10/11:We’re extending repos until Jan 2020

10/23:We’re expanding overnight repo offering to $120B, $45B term

This reinforces the point that I believe is behind this as I pointed out on the 25th of September

The question to my mind going forwards is will we see a reversal in the QT or Quantitative Tightening era? The supply of US Dollars is now being reduced by it and we wait to see what the consequences are.

This added to the US Dollar shortage we have been looking at for the past couple of years or so. It would seem that the US Federal Reserve is worried about a shortage at the end of this month which makes me wonder what they state of play will be at the year end when many books are squared? Also in terms if timing we will get the latest repo announcement at pretty much the same time as Mario Draghi starts his final ECB press conference.

The Riksbank of Sweden

It has made this announcement today.

In line with the forecast from September, the Executive Board has therefore decided to leave the repo rate unchanged at –0.25 per cent. As before, the forecast indicates that the interest rate will most probably be raised in December to zero percent.

I will come to my critique of this in a moment but we only have to progress another sentence or two to find that the Riksbank has provided its own critique.

The forecast for the repo rate has therefore been revised downwards and indicates that the interest rate will be unchanged for a prolonged period after the expected rise in December.

That is really quite a mess because we are supposed to take notice of central bank Forward Guidance which is now for lower interest-rates which will be achieved by raising them! Time for a reminder of their track record on this front.

As you can see their Forward Guidance has had a 100% failure rate. You do well by doing the reverse of what they say. As for now well you really could not make the bit below up!

If the prospects were to change, monetary policy may need to be adjusted going forward. Improved prospects would justify a higher interest rate. If the economy were instead to develop less favourably, the Executive Board could cut the repo rate or make monetary policy more expansionary in some other way.

QE

Well that never seems to go away does it?

In accordance with the decision from April 2019, the Riksbank is purchasing government bonds for a nominal total amount of SEK 45 billion, with effect from July 2019 to December 2020.

The central bank will keep the government sweet by making sure it can borrow very cheaply. The ten-year yield is negative albeit only just ( -0.03%) although in an undercut Sweden is running a fiscal surplus. That becomes really rather odd when we look at the next bit.

The Economy

I have criticised the Riksbank for pro-cyclical monetary policy and it seems set to do so again.

after several years of good growth and
strong economic activity, the Swedish economy is now growing more slowly.

So they have cut interest-rates in the good times and now seem set to raise them in weaker times.

Next comes this.

As economic activity has entered a phase of lower growth in
2019, the labour market has also cooled down. Unemployment is deemed to have increased slightly during the year.

If we switch to last week’s release from Sweden Statistics we see something of a challenge to the “increased slightly” claim.

In September 2019 there were 5 110 000 employed persons. The unemployment rate was 7.1 percent, an increase of 1.1 percentage points compared with September 2018……In September 2019, there were 391 000 unemployed persons aged 15─74, not seasonally adjusted, an increase of 62 000 compared with September 2018.

If we move to manufacturing then the world outlook seemed to hit Sweden in pretty much one go in September according to Swedbank.

The PMI dropped by 5.5 points in September to 46.3 from a downward revision of 51.8 in August. This is the largest monthly decline since autumn 2008 and was part of the reason why the PMI fell in the third quarter to the lowest level since early 2013.

Comment

The US Federal Reserve is the world’s central bank of last resort and currently that is not going especially well. So far it has added around US $200 billion to its balance sheet and seems set to push it back over US $4 trillion. Yet the problem seems to be hanging around rather than going away as it feels like a plaster is being applied to a broken leg. A gear or two is grinding in the banking system.

Moving to Sweden we see a case of a central bank adopting pro-cyclical monetary policy and now finds itself planning to raise interest-rates in a recession. Yet the rise seems to make interest-rates lower in the future! I am afraid the Riksbank has really rather jumped the shark here. It now looks as if it has decided that negative interest-rates are a bad idea which I have a lot of sympathy with but as I have argued many times the boom was the time to end it.

Sweden has economic growth of 4% with an interest-rate of -0.5% ( 28th of July 2017)

The Investing Channel